Wednesday, December 18, 2013

The dollar’s demise and the rise of Bitcoin

One
of the questions investors have been asking lately concerns the outlook for the
U.S. dollar index.Investors are
understandably concerned by the dollar’s weakness and worry that perhaps that
any notable increase in inflation could lead to further erosion in the dollar’s
value.

In
a weak dollar environment, investors actively search for alternatives to cash
which provide growth and relative protection from dollar weakness. Until 2011 the investment safe havens of
choice were gold and silver; prior to that it was real estate. The new alternative investment versus the
dollar is growing in popularity and becoming more widely accepted as a
legitimate financial vehicle. I’m referring
to Bitcoins, the open-source, peer-to-peer payment network and digital currency.

Bitcoins
made news recent when the People’s Bank of China announced that it was
prohibiting Chinese financial banks from accepting Bitcoins as legal tender
currency. The announcement caused a 20
percent drop in the value of Bitcoins, though the value later rebounded. Bitcoins have been one of the big financial
success stories of the year, and the continued increase in the coin’s value has
prompted speculation that a “Bitcoin bubble” has developed.

Randall
Forsyth, writing in a recent Barron’s
column, nailed it down when he wrote: “Clearly, [Bitcoin] is a speculative
vehicle for the masses.” Another Barron’s writer, Michael Kahn, likened
Bitcoin’s bull market to the tulip mania of 1637. “The dangers of buying into a bubble,” he
wrote, “are the same as attempting to sell it short. It could double from here, just as easily as
it could fall by half.”

Others
believe that Bitcoin’s success and soaring value represent a repudiation of the
weak U.S. dollar. It’s no coincidence
that Bitcoin’s popularity has greatly increased in the wake of the gold bear
market; Bitcoins have apparently supplanted the yellow metal as a safe haven du
jour among libertarians and others worried about a potential dollar
collapse.

Evaluating
the Bitcoin’s value is a difficult task.
Regardless of the metric, whether fundamental or technically based,
analysis of Bitcoins is a tall order without something with which to make
relative comparisons. The lack of
long-term historical price data is another impediment to making informed risk
assessments regarding Bitcoin’s future. David
Woo, currency strategist at Bank of America Merrill Lynch, recently published a
valuation report on Bitcoin. He valued
the digital currency at $1,300, cautiously adding that this number is based on several
assumptions that can’t be firmly quantified.

Woo
concluded that the rapid growth of the digital currency’s value “would suggest
the price appreciation has been more about Bitcoin as a store of value or
investment than as a medium of exchange.”
He also noted that Bitcoin transactions have diminished as the coin’s
price has increased.

An
examination of the Bitcoin “long-term” chart is revealing. Any market technician worth his salt will
preface an analysis of this chart by pointing out that, aside from transaction
volume, there is little data with which to make an informed forecast other than
price itself. That said, a classical
chart pattern analysis suggests there is more upside in the coin’s future
before the bull market in its value comes to an end. The breakout to new highs in Bitcoin’s price
which occurred in November was preceded by six months of base-building; in
classical chart analysis this is normally a good indication of a significant
upside run ahead. Below is a weekly
chart for the Bitcoin, courtesy of www.bitcoincharts.com.

As
a speculative medium, Bitcoin is an undisputed success. As a medium of exchange, the currency has
been less than ideal. The serious
shortcomings of Bitcoin as a dollar substitute were chronicled in an amusing
article by Jessica Roy in a recent issue of Time
magazine. As she pointed out, “Very
few brick-and-mortar stores actually accept bitcoins today.” And for the ones that do, the transactions
can be exceedingly complex and time consuming.

While
there may be additional upside ahead for Bitcoin’s value in the intermediate
term, the ultimate fate of Bitcoin is likely to be that of every other dollar
hedge we’ve seen in recent years, namely a collapsed value.

Returning
to our analysis of the dollar, while the dollar index has been weak in recent
months there is reason to believe we’ll see a meaningful rally at some point in
2014. If expectations of a stock market
melt-up and subsequent melt-down is realized it will almost certainly be
accompanied by a major dollar rally owing to investors’ needs to get
liquid. Moreover, since the end of the credit
crisis dollar rallies have been bi-annual affairs and since 2013 was mostly a down
year for the dollar, 2014 should see a rally assuming this relationship remains
alive.